General Equilibrium Model for Monetary Policy Responses to Macroeconomic Instabilities in Developing Economy: A Ghanaian Perspective

Abstract

The study develops a standard New Keynesian model to examine how monetary authority reacts to both domestic and external shocks as well as how its policy decision impacts the general macroeconomy in developing African economy. Using Bayesian estimation techniques and a Ghanaian dataset, the article also seeks to determine the best-suited monetary policy rule for Ghana and countries with similar characteristics. The basic finding is that a forward-looking Taylor rule—where authority reacts to one-period-ahead inflation deviation from target alongside the current output gap—is the most appropriate monetary policy rule for Ghana. Another salient finding is that variations in output are mainly driven by price markup, labour supply, monetary policy and productivity shocks across the forecast horizons. In addition, the dominant determinants of inflation are exchange rate risk premium and price markup shocks. Collectively, the article also unveils that monetary policy responses to macroeconomic shocks are broadly in line with conventional economic theory. There is also conspicuous evidence that the general equilibrium model with representative consumers is practically suitable for monetary policy analysis in Ghana, as contractionary monetary policy impulse is able to contemporaneously induce disinflation and output contraction. Given the strong evidence of a large segment of the unbanked population in Ghana, the findings in this study could be verified based on a model that allows for the co-existence of optimizing and non-optimizing consumers. JEL Classification: B41, C5, C11, D11, D21, D41, D42, E2, E12, E43, E52, E58, F31, F41